1303723

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Title: Determinants of Economic Growth in the UK from 1980-2014.

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Abstract:
This paper examines the determinants of economic growth in the UK over

the period of 1980 to 2014. Time series data is used to predict models and

conclusively find evidence of how influential the chosen determinants actually are.

Two regressions are carried out. The first regression is for the whole period and the

second is with a dummy variable for the 2007-2008 recession.

When the whole period was regressed, results suggested that the UK’s

economy has been growing with the unemployment rate the largest factor behind

this. Results implied an inverse, highly insignificant relationship between the pair.

Whereas results suggested a positive relationship between economic growth and

inflation as well as economic growth and exports. Foreign direct investment (FDI)

was the only variable where no relationship was found with economic growth.

A recession has a negative effect on economic growth. This was evident from

the results. Similarly to the first regression, inflation and unemployment both showed

the same relationship. However during this period, as expected, no relationship was

found between economic growth and exports as well as economic growth and

foreign direct investment.

Acknowledgements

I would first like to thank my parents for all being providing me with the support and
guidance needed to complete this dissertation.

I also wish to thank my dissertation tutor, Fabio Spagnolo, who provided invaluable
help and advice, without which it would not have been possible to complete this
dissertation.

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Contents

1. Introduction..........................................................................................................5

2. Literature Review.................................................................................................6

2.1 Effects of Inflation on Economic Growth…………..............................................6

2.2 Effects of Unemployment on Economic Growth.................................................8

2.3 Effect of Foreign Direct Investment on Economic Growth..…………………….10

2.4 Effect of Taxes on Economic Growth………….…............................................12

3. Data Selection and Descriptive Statistics...........................................................15

3.1. Key Variables…………....................................................................................15

3.2. Descriptive Statistics.......................................................................................17

4. Methodology…………….....................................................................................22

4.1. The Model.......................................................................................................22

4.2. Unit Root Testing & Stationarity…………………………………...…….……..23

4.3. Unit Root Test Results…………………………………...…………....………...24

5. Results….………………………………………………….......……………………..26

5.1. Ordinary Least Square Estimator & Results……………….…….......……….26

5.2. Ordinary Least Square Estimator with Dummy Variable & Results……..….29

6. Conclusion……………………………………………….........................................32

7. References………………………………………..…….….....................................34

8. Appendix…………………………………………………........................................36

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1. Introduction

The debate of what exactly determines economic growth has been going on for

a long time. A lot of research has been carried out to see what exactly increases

and decreases growth. Both sides of the argument have strong but conflicting cases.

Instead of finding just any determinant of economic growth it is important to find the

most influential determinants of economic growth.

The UK has faced three recessions during the period from 1980 and 2014. On

each occasion the growth rate in the UK was affected and showed signs of

weakening. Similarly during times of excessive growth, there are some particular

variables that can and have influenced the growth rate more than others. The

independent variables in this study are; inflation, unemployment, foreign direct

investment and exports.

Each of these variables are major contributors in their respective sub fields on

the way they affect the UK economy. For example, inflation is set by the government

as a reaction to the country’s economic situation. Unemployment depends on firms

and consequently has an effect on consumption. FDI depends on the strength of

foreign countries and investors that are investing into the UK. Lastly exports relies

on strength of foreign countries and consumers that are importing from the UK.

This paper will analyse, test and study the relationship between these variables

and the GDP rate to see whether they are strong determinants of economic growth.

The second regression will test to see the effect these determinants have on

economic growth during times of a recession. Results are expected to differ during

a recession because of the negative effect a recession can have on an economy’s

determinants and consequently its economic growth.

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2. Literature Review

In this section, past literature on this topic are introduced. A discussion of each

variable believed to have an impact on economic growth in the UK will be discussed.

There will be comments on the conclusions they reached and what this means for

this paper.

2.1 Effects of Inflation on Economic Growth

Theoretically, there are counter arguments surrounding inflation and economic

growth. According to, Kwan (2013) inflation subsequently follows the growth rate

after a lag. Studying the relationship between inflation and growth in China, a

positive relationship, was found between the two variables. Results showed that

changes in the inflation rate follow approximately three quarters after changes in

economic growth. However such results depends on the government and differ

between countries. The government’s reaction to a boom period or recessionary

period is to adjust inflation rates in order to match the economy’s standard of living.

Consequently this positive relationship is created.

Conversely, Barro (1995) boasted an inverse relationship between inflation and

growth. It was stated that an “increase in the average inflation rate by 10 percentage

points per year is estimated to lower the growth rate of real per capita GDP by 0.2-

0.3 percentage points per year” (Barro, 1995, p.9). This was further supported by

Chen & Feng (2000) who found that “high and volatile inflation has a negative effect

on growth” (Chen & Feng, 2000, p.1). Both Kwan (2013) and Bittencourt, Van Eyden

& Seleteng (2015) investigated the role of inflation rates in determining economic

growth.

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It was concluded by Bittencourt, Van Eyden & Seleteng (2015) that the

relationship between inflation and economic growth was and is not as

straightforward as the other determinants. There is clear indecision and results are

very inconclusive with many studies counter acting the other. Depending on which

paper you look at, there is justification to support both sides of the argument.

Unlike Kwan (2013), most of Bittencourt, Van Eyden & Seleteng (2015) literature

review suggested that high inflation is detrimental to growth. Particularly because of

the macroeconomic uncertainty it passes on to areas such as productivity, which is

vital in the progression of an economy’s growth. Their results from the OLS study

found there to be a negative and statically significant relationship between the two

variables.

Similarly Barro (1995) found that the extent to which inflation affected economic

growth, depended on the level of inflation being considered. For example, he found

the relationship between inflation and economic growth to be statically insignificant

for inflation levels below 15% (Barro, 1995, p.9). The other studies did not stress the

differential impact of high inflation instead of low inflation as much as Barro (1995)

did. They concentrated on just the linear relationship.

This study will test whether the theory expressed by Kwan (2013) goes in line

with the UK or whether the theoretical theory of an inverse relationship is still valid.

Many studies that have been carried out to test the relationship between inflation

and growth have been panel studies however this study will be carrying out a time

series study in order to find specific results for a specific country. Instead of finding

a variety of results, no clear conclusion and generalising to fit the same result with

different countries. This does not mean that previous panel research is not of

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importance. In fact it will give this study a platform to build upon and counter. Due

to the indecision throughout previous studies the research in this study will include

attributes forgotten in other studies and see if there is a clear decisive result,

something the others don’t do. One thing to bear in mind which the likes of

Bittencourt, Van Eyden & Seleteng (2015) did not mention, was that it is important

to take into account the economic strength of a country when thinking about the

extent to which inflation can determine economic growth. This is because,

depending on what period of the economic cycle an economy is in, will determine

the impact inflation will have on economic growth. Therefore when interpreting the

results, whether the UK is in a recession at the time or not will be considered.

2.2 Effects of Unemployment on Economic Growth

Extensive research has been carried out in the past to find out the relationship

between unemployment and economic growth. As said in Tatoglu’s (2011) study,

Economists of the likes of Arthur Okun (1962) concluded that for every percent of

unemployment above a certain level of the labour force implied a three percent

decrement in real GDP. Therefore implying that economic growth and

unemployment have an inverse relationship regardless of what country is being

studied. In addition Zaman, Donghui & Imran (2016) said that the “workforce of any

country is not only a productive agent of goods and services but these also play a

role in a country’s purchasing power which in-turn is a fuel for the economy” (Zaman,

Donghui & Imran, 2016, p.293). This echoes the importance of the labour market in

an economy. Tatoglu’s (2011) finding proved that cyclical fluctuations have a

permanent effect on the level of unemployment.

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Surprisingly, Barro (1995) concentrated on a large sample of economies and he

found it difficult to come up with a clear conclusion as to whether one variable

affected the other. Barro (1995) and Helliwell (1994) should be credited for imputing

the maximum amount of countries that it possibly could in his sample of 125

countries. However it may have been a good idea to use a fairly average size group

to see the linkage between determinants of growth in countries or go one step further

and compare only a small handful of countries.

The unemployment rate is effected by the cyclical changes on a country. If it

going through a period of recession and their economic growth is very low, then this

would have a permanent effect on the level of unemployment rate. After an economy

is hit by a recession, majority of the effect is usually in the aftermath when firms

begin to shut down and consequently workers begin to lose their jobs. The resulting

effect has an impact on the labour market for a longer period than one may expect.

Zaman, Donghui & Imran (2016) found there to be a significant negative

relationship between unemployment and economic growth. It was agreed upon by

them that a low level of unemployment is vital for an economy to have high growth.

The study highlighted that structural changes can not contribute to economic growth

if there is social costs such as persistent unemployment. This suggests that if an

economy wants consistent economic growth, they would need to make sure there

unemployment rate is as low as possible. This emphasises the importance of

unemployment as a determinant of economic growth.

As stated by Tatoglu (2011), “the significance of the relationship between

economic growth rate and unemployment rate vary between countries” (Tatoglu,

2011, p.1). Therefore when testing for the inverse relationship between the two

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variables, it would be better to concentrate on one country or a limited amount

instead of a whole range. Critically the main objective of the study is to find

conclusive relationships and results. Some studies got carried away with using

many countries and comparing. Dissimilar to the body of evidence, this study aims

to analyse the relationship between unemployment and economic growth in the UK

in great detail, in order to obtain a clear result. Furthermore, it would be worth

investigating the relationship between the two variables in more detail because

Zaman, Donghui & Imran (2016) implied how after the 90’s recession, economic

growth dropped and unemployment increased. The data in this study spans over 3

recessions therefore it would be interesting to see whether this impact is consistent

with the other recessionary periods.

2.3 Effects of Foreign Direct Investment on Economic Growth

Li & Liu (2005) carried out their study from 1970-1999 however only found FDI

and growth to have a relationship post the mid 1980’s. Thus, it would be beneficial

for future research to investigate why only after 1980 was a relationship between

the two variables formed. Nevertheless, FDI has been tested post 1980 by many

studies including Apergis, Lyroudi & Vamvakidis’s (2008) study, with most of the

conclusions pointing towards FDI contributing to an increase in economic growth.

FDI is an investment from a foreign company to another country of interest. A lot of

positives occur as a result of FDI, such as increased production and increased jobs

as they are critically important. Despite this, the extent of benefits resulting from FDI

purely depends on the countries current economic situation.

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Elkomy, Ingham & Read (2016) and Li & Lui (2005) believed that the difference

in the effect FDI had on each country was because of the behaviour of the

technology gap between developed and developing countries. They both came to

the conclusion that the relationship was positive however the significance of the

results depended on the country being investigated, purely because of one countries

wealth and resources against another. In the same way Elkomy, Ingham & Read

(2016) found that for authoritarian countries, the impact of FDI is large in comparison

to a country that is already fully developed and politically free. When testing, they

found there to be “no role can be established for FDI as a driver of economic growth”

(Elkomy, Ingham & Read, 2016, p13). This is quite surprising by all means but can

be understood if considered that the sample contained 61 countries with majority of

them transitioning countries.

Conversely, another study found there to be empirical evidence to suggest a

relationship between FDI and economic growth. They identified that the strength of

this relationship was limited “for those transition countries that are characterised by

high levels on income and have implemented successful privatisation programmes”

(Apergis, Lyroudi & Vamvakidis, 2008, p.37). This emphasises a similar problem

Elkomy, Ingham & Read (2016) had when interpreting their results. From both

studies it is clear that despite there being a clear relationship between the two

variables, external factors have a significant impact. Therefore there is evidence to

show that there are other determinants of economic growth that may have a greater

effect on economic growth than FDI, regardless of external factors.

As mentioned in the concluding remarks in the study carried out by Elkomy,

Ingham & Read (2016), using a fair and equal sample of countries with similar

economic situations would have been a better way of carrying out the study. This

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study will be used to see whether FDI’s insignificance was in fact due to the chosen

data or if it was simply because of the relationship each variables actually holds.

Something this article does well in comparison to others is to find the subsets behind

variables and then it’s consequent effect on economic growth instead of looking at

the casual relationship. Many of the previous studies fail to identify this. From Heo

& Tan’s (2001) results, it is apparent that the study should be on one particular

country, otherwise external factors will play a large role in the results. For example,

it would be inequitable to test an economically supreme country against an

economically deprived one because of numerous reasons with one being the fact

that they are at different points in the economic cycle. The extent to which, if any,

that the determinants will have on a country will vary between countries.

2.4 Effects of Taxes on Economic Growth

Another determinant of economic growth is tax. In theory, a decrease in tax leads

to an increase in economic growth, whether it is company related, worker related or

consumer related. A tax cut results in, companies making more profit, workers earn

more and consumers have more money to spend. As stated by Arnold (2014),

“some economies propose promoting economic growth by cutting taxes on income”

(Arnold, 2014, p.444). This is based on the assumption that as taxes are cut,

workers will work more, consequently leading to an increase in output.

Poulson & Kaplan’s (2008) analysis revealed, a significant negative impact of

higher marginal tax rates on economic growth. A usual point that is revealed from

Poulson & Kaplan’s (2008) finding is that the status with higher marginal income tax

appear to be at a disadvantage in achieving higher rates of economic growth. A

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strength of Poulson & Kaplan (2008) study is the substantial detail of the subsets

behind a drop in taxes and its eventual effect on economic growth. If only taxes were

cut, no other variable altered, and no one was affected, then economic growth would

remain the same. However because the tax rates are being switched from a higher

rate to a lower rate, individuals and firms will engage in more productive activity and

it is this consequent that leads to higher rates of economic growth.

Arguably, when looking at the time span as large as 10-20 years, you must

consider the “ability of individuals and firm’s responsiveness to state taxes” (Deskins

& Hill, 2008, p.336). Thus leading to the hypothesis that individuals and firms have

increased their sensitivity to taxes over time. Despite the study based on the US,

this hypothesis can be taken as a general notion, regardless of the country being

studied.

Critically some argue that the analysis of the relations between economic growth

and taxes is simple as it ignores a number of other issues as well as the belief that

an increase in taxes can in fact lead to an increase in economic growth. In addition,

if the government used the collected tax revenues to fund in social goods, especially

goods resulting in external benefits, the economic growth could be positively

influenced by taxation. Both Koch, Schoeman & Tonder (2005) and Poulson &

Kaplan (2008) agreed on this saying that the variation in results could be because

of many factors such as differences in how economic activity or tax policies are

measured. As well as the differences in methods used instead of an actual change

in tax. Furthermore when looking at any analysis of the relationship between

taxation and economic activity, you must account for other variables, for example

economic growth in an economy could be high due to international factors however

there are so many factors that it is impossible to include all of them in the model. In

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spite of doubting the economic theory and thinking the overall effect of a tax

decrease would not lead to an increase in growth, the results proved it right and

concluded that a drop in tax does in fact lead to an increase in economic growth.

Due to the importance of labour and capital in determining economic growth, it

is surprising that the relationship between economic growth and taxes has not

featured more predominantly. This may be because of the difficulty in gathering

results for studies on the UK. In addition, when looking deeper into the effect of

taxes on economic growth, it is clear that majority of the studies that did test for the

relationship pointed towards one direction and conclusion. This decisiveness gives

an indictor to which way results would go if it was tested in this study. Furthermore,

when testing for the relationship of economic growth and taxes in the future it’s worth

measuring the magnitude of this relationship by looking at its significance. This will

emphasise the extent to which one variables affects another instead of just a causal

relationship.

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3. Data Selection & Descriptive Statistics

The paper uses quarterly data from 1980 to 2014 for five variables namely GDP,

inflation, exports, unemployment and FDI. To make the results of this study reliable

to the reality of today, we use a smaller range and a total number of 139

observations. Majority of the data has been collected from DataStream. The reason

for the 24 years range is because a large amount of studies do their research on

such a wide time scale that it defeats the purpose of the actual study. The data is

measured on a quarterly basis which again aids the depth in which this study will go

in finding the relationship between the independent variables and economic growth.

In addition, this study will also only concentrate on the UK, unlike many other studies

which use a vast amount of country and come to no definite conclusion. This study

should give a definite indication as to what determines economic growth in the UK

during the whole period and during the recession of 2007.

3.1 Key Variables

In this study, GDP will be the dependent variable because it is the most efficient

measure of economic growth. If GDP is increasing at a rapid rate, this consequently

means the economy is growing at the same rate. This correlation has made GDP

the best measure of economic growth in macroeconomics as well as this study. The

data is measured on a quarterly basis as it would be the best frequency to spot

specific trends or patterns created on a quarter to quarter basis. Many of the studies

in recent years have used GDP as a measure of economic growth. Furthermore,

finding data for this variable is easily obtainable for the UK. Economists measure

national output by calculating the market value of final goods and services that an

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economy produces during a specific period of time. The quarter to quarter

comparison will indicate if the economy is growing, is stagnant, or is contracting.

Inflation has been tested on various occasions and on various occasions, there

has been opposing results. Some studies argue that inflation increases economic

growth and some decrease it. The inflation rate will be presented from the data

collected from data stream. Inflation in this study is measured by CPI which basically

highlights the change in price on a yearly basis. The option to use retail price index

as a measure on inflation was there however because of the volatility that can be

involved in RPI especially in the UK, CPI seemed like the better option.

One of the best indicators of how well an economy is doing is by looking at the

unemployment rate. The data for unemployment was found from World Bank. The

unemployment rate is the amount of people who are actively searching for a job but

do not have one. Therefore this would present a great indication as to how many

despite having the capabilities to work, are not working. If this is a high rate then this

would suggest that the economy is not doing so well and consequently will affect

the growth rate of that particular country.

Another important variable is exports. This essentially determines how well the

economy is doing at a global level. If they are exporting at a high rate, then the influx

of income from other countries will benefit the UK at a greater rate. In theory exports

and economic growth are positively correlated with the data collected for this study

spanning on a quarterly basis from 1980-2014. The UK has many strong and loyal

trade links, therefore putting them in a strong position in terms of their export market

before and even after Brexit. Having said that, exports are easily distorted by not

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just external national factors but also worldwide factors that may not directly impact

the country itself.

Lastly foreign direct investment is another variable that will be included in this

study. Instead of oversea consumers buying from the UK, with FDI, oversea

investors will be investing in the country. Therefore having the potential of increasing

the economic growth rate of that country. FDI increases economic growth of that

country by creating jobs and increasing output that was not available before. The

data collected was again from Data Stream and is measured as a percentage of

total investments. This would be the best measure for FDI in the UK, as this will

highlight how much of the total investment into the UK was in fact foreign. Therefore

providing a more precise result.

3.2 Descriptive Statistics

In order to observe the trends for each individual variables, they are plotted on

five different graphs from 1980 Q1 to 2014 Q4.

The growth rate in the UK towards the beginning of the range is 23.2% and is

the start of the first recessionary period. This is why there was a sharp drop from

1980Q1 and 1982Q4. Throughout the UK’s history, the economy has been hit by a

recession in the early 1980’s, 1990’s and recently 2007. Arguably 2007 was the

worst of the 3 most recent recessions as quarter to quarter growth rate reached an

all-time low of -4.1%. Towards the end of 2008 was the first time UK’s GDP growth

rate went into negative. Conversely, some years have shown rapid growth in the UK

such as 1987 and 2000. Despite the growth rate in the UK in 2014Q4 not as high

as previous levels, the rate is currently moving at a progressive steady pace, a

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similar level as to when the UK came out of the recession in the early 1990’s. The

sudden drop in growth rates during the periods of recession emphasises the severe

and dramatic impact a recession can have on a countries economy.

The growth rate and inflation rate move in the same direction however, the

correlation between the pair, when analysing the graphs is very weak. This is

evident in graph 2, when during the 1980 and 1990 recession, when growth

dropped, inflation dropped too with a slight lag. Currently the inflation rate in the UK

is 0.9% which is a massive difference to what the inflation rate was in 1980.

Furthermore, the inflation rate is adjusted to match the economic situation therefore

from looking at the graphs it could be a reaction instead of a determinant. The

current rate is declining which is the opposite to the direction of the growth rate. The

Bank of England has a main objective to keep the inflation rate in the UK as close

and constant as possible to 0. As seen from previous results, it is clear that a

recession can significantly affect this objective of the Bank of England and may

reluctantly force them to change this rate to a higher level.

The export rate in the UK has been very volatile between the periods 1980 and

2014 and is currently far from the high levels that it reached in 2006. The rates are

so volatile because of the number of factors that can have an effect on exports. This

could explain the lack of relationship shown when comparing graph 1 to graph 3.

This is also evident from the amount of times the export rate spiked up and down

throughout the period under investigation. The export rate reached its highest level

at 25% just before the recent recession and reached its lowest point just after the

recession. This indicates the effect a recession can have on the export rate. Unlike

the other determinants during times of recession, the export market is affected way

more dramatically than the others. Arguably the countries that are buying the

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products are not facing the same economic problems, they will continue to import

as normal. However the difference is that the rate at which the exports are produced

will not be as high. This will majorly affect the country. This is clear from graph 3.

FDI is a variable that usually goes in line with economic growth. The percentage

of FDI out the total investment is fairly constant throughout the period 1980 to 2014.

However during times of recession and rapid growth periods in the UK, FDI has

been making sharp movements. The year 2000, 2005 and 2007 were three periods

were FDI was at a percentage level in excess of 100%. During these periods the

economic growth rate also spiked up but not at a rate as rapid rate as FDI. This

might be because FDI is the investment from foreigners. They are in a position

where they can extract money from the country at a fast pace and shield themselves

from the likes of a recession. Therefore if they fear a recession or expect a rapid

expansionary period, they will invest or extract accordingly. This is usually at a rapid

rate which is evident on graph 4. Likewise during a period of a recession investors

may not want to invest in the UK and only find it feasible to invest during at a time

the economy is either coming out of a recession or during a period of consistent

growth. This is another reason for these rapid increases and decreases in the FDI

percentage rate.

From analysing the graphs, it is evident that an increase in unemployment leads

to a decrease in economic growth as less people are available to be producing the

goods and providing the service. Unemployment is one of the determinants that are

instantly affected by the growth of a country as well as take one of the longest times

to recover from such a shock. This is highlighted when comparing graph 1 to graph

5. If it is doing well then the unemployment rate is low and conversely when the

economy is not doing so well like in a recession, the unemployment rate is usually

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high. In graph 5 during recessions the unemployment rate spiked to high levels,

once as high as 10%. During these similar periods the growth rates were at an all-

time low. Overall from the 1980 to 2014, the unemployment rate has dropped by 1%

however when comparing the unemployment rate from the highest point it reached

which was the aftermath of the 1980 recession to now, the unemployment rate has

dropped by a large 5.9%.

Conclusively these graphs and explanations should give a preliminary insight on

what to expect when delivering the models and it will be interesting to see whether

the findings support or contrast many of the previous studies.

GROSS DOMESTIC PRODUCT

30
PERCENTAGE (%)

20

10

0
Q1 2009

Q1 2011

Q1 2013
Q1 1980
Q1 1981
Q1 1982
Q1 1983
Q1 1984
Q1 1985
Q1 1986
Q1 1987
Q1 1988
Q1 1989
Q1 1990
Q1 1991
Q1 1992
Q1 1993
Q1 1994
Q1 1995
Q1 1996
Q1 1997
Q1 1998
Q1 1999
Q1 2000
Q1 2001
Q1 2002
Q1 2003
Q1 2004
Q1 2005
Q1 2006
Q1 2007
Q1 2008

Q1 2010

Q1 2012

Q1 2014
-10

YEARS

Graph 1: Gross Domestic Product

INFLATION RATE
25
PERCENTAGE (%)

20
15
10
5
0
2011-Q1
2012-Q1
2013-Q1
2014-Q1
1980-Q1
1981-Q1
1982-Q1
1983-Q1
1984-Q1
1985-Q1
1986-Q1
1987-Q1
1988-Q1
1989-Q1
1990-Q1
1991-Q1
1992-Q1
1993-Q1
1994-Q1
1995-Q1
1996-Q1
1997-Q1
1998-Q1
1999-Q1
2000-Q1
2001-Q1
2002-Q1
2003-Q1
2004-Q1
2005-Q1
2006-Q1
2007-Q1
2008-Q1
2009-Q1
2010-Q1

YEAR

Graph 2: Inflation Rate

20
 PERCENTAGE (%) PERCENTAGE (%) PERCENTAGE (%)
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-20
-10
0
10
20
30

0
50
100

-100
-50
150

0.00
5.00
10.00
15.00
Q1 1980
Q1 1980 Q1 1980
Q1 1981 Q1 1981
Q1 1981

Graph 3: Exports
Q1 1982 Q1 1982
Q1 1982 Q1 1983
Q1 1983 Q1 1983
Q1 1984 Q1 1984
Q1 1984 Q1 1985
Q1 1985 Q1 1985
Q1 1986 Q1 1986

Graph 5: Unemployment Rate

Q1 1986 Q1 1987
Q1 1987 Q1 1987
Q1 1988 Q1 1988

Graph 4: Foreign Direct Investment

Q1 1988
Q1 1989 Q1 1989
Q1 1989
Q1 1990 Q1 1990
Q1 1990
Q1 1991 Q1 1991
Q1 1991
Q1 1992 Q1 1992
Q1 1992
Q1 1993 Q1 1993
Q1 1993
Q1 1994 Q1 1994

21
Q1 1994
Q1 1995 Q1 1995
Q1 1995
Q1 1996 Q1 1996
Q1 1996
Q1 1997 Q1 1997
Q1 1997
EXPORTS

YEAR

Q1 1998

YEAR

YEAR
Q1 1998 Q1 1998
Q1 1999 Q1 1999
Q1 1999
Q1 2000 Q1 2000
Q1 2000
Q1 2001

UNEMPLOYMENT RATE
Q1 2001 Q1 2001
Q1 2002 Q1 2002
Q1 2002
FORIEGN DIRECT INVESTMENT

Q1 2003 Q1 2003
Q1 2003
Q1 2004 Q1 2004 Q1 2004
Q1 2005 Q1 2005 Q1 2005
Q1 2006 Q1 2006 Q1 2006
Q1 2007 Q1 2007 Q1 2007
Q1 2008 Q1 2008 Q1 2008
Q1 2009 Q1 2009 Q1 2009
Q1 2010 Q1 2010 Q1 2010
Q1 2011 Q1 2011 Q1 2011
Q1 2012 Q1 2012 Q1 2012
Q1 2013 Q1 2013 Q1 2013
Q1 2014 Q1 2014 Q1 2014
1303723

4. Methodology

This section will cover the methodology used to create the models. There will

also be a discussion on whether the variables are stationary, on the regressions

run and finally along with the findings and analysis on whether they support any

previous studies.

4.1 The Model

An Ordinary Least Square (OLS) model will be used to estimate the effect the

determinants have on economic growth in the UK. It will be used to test from the

period 1980Q1 to 2014Q4 as well as specifically test for the effect these

determinants have during a recession. In order for the OLS estimator to be the

best it can possibly be, there are certain assumptions that must be met.

Firstly all the parameters of alpha and beta must be linear. Secondly, the

expected value of the error term must be zero for all observations. The third

assumption is about homoscedasticity and about how the variance of the error

term must be constant in all x variables and over time. Homoscedasticity implies

that the model uncertainty is identical across observations. The fourth assumption

is that the error term is independently distributed and not correlated.

If all Gauss Markov assumptions are met then the OLS estimator and beta are

the best linear unbiased estimators (BLUE). If it is the best, this means the

variance of the OLS estimator is minimal. In addition, if the model is not linear,

then the OLS is not applicable and another method would be needed. Lastly in

order to be unbiased estimators, the expected values of the estimated beta and

alpha must equal the true values of x and y.

22
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The first regression will be:

GDPi = β0 + β1INFi + β2EXi + β3FDIi + β4UNEi + ei

The second regression will be:

GDPi = β0 + β1INFi + β2EXi + β3FDIi + β4UNEi + δdi + ei

In these model, gross domestic product (GDP) is measured as the change in

the GDP rate on a quarter to same quarter basis. This is followed by the dependent

variables which start with inflation (INF). This is measured as a percentage rate.

This is similar to the unemployment rate (UNE) which is also measured as a

percentage rate. The export rate (EX) is measured as a year on year percentage

change. Lastly, the foreign direct investment rate (FDI) is measured as a percentage

of the total investment.

For the second regression an intercept dummy has been added to the original

regression. This is to test the effect a recession has on the growth rate. The dummy

variable is to quantify the values from 2007Q1 to 2008Q4.

4.2 Unit Root Testing & Stationarity

Before running any regression, it is important to find out whether the data found

is stationary or not. Whether it is or not can have a major impact on the way the

study is carried hence forth. A stationary series is one which it’s mean and variance

are constant over time. Whereas a non-stationary series does not. If data is non

stationary it can influence behaviour in a regression and consequently lead to

spurious results. For example two variables may show a strong positive relationship

but in fact they may have no relationship at all. In addition, non-stationarity variables

23
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could cause severe model misspecification and unreliable results, if not eradicated

early on. The way this problem can be solved is by taking the first difference however

even before that, we need to test via the Augmented Dickey Fuller Test (ADF) to

see whether the data found is in fact stationary.

The results after carrying out the test should indicate whether to continue as

normal or make adjustments. The null hypothesis is rejected if our t value is smaller

than the t critical or if our p value is smaller than our p significance level. If we accept

the hypothesis that means our data is non-stationary. If the results show non-

stationary behaviour then the variance must be first differenced to make it stationary.

4.3 Unit Root Test Results

The inflation variable looks non stationary from visual inspection however the

results when the ADF test is carried out, show that the variable is stationary. This is

because the p value is 0.02, which is smaller than the 5% significance level. Despite

the conflicting evidence, this study will follow the ADF indications.

Furthermore, from table 1 it is clear that the ADF results for unemployment rate

is non stationary. The data of this variable is above the 10% critical level therefore

suggesting the need for the data to be first differenced. For example the p value for

unemployment is 0.42 which is far greater than 0.10. The data is therefore non

stationary and as said above, this could influence the data and give unreliable

results.

In comparison the p values of other variables such as GDP, exports, inflation

and FDI, suggest that the data for these variables is stationary. Therefore these

variables in particular will not need to be first differenced. According to ADF, we

24
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need to take the first difference of unemployment. After taking the first difference, it

is evident that they became stationary with all the p values less than 0.05. This can

be highlighted at the bottom of table 1.

25
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5. Results

In this section, the results will be discussed for both regressions. The

significance and the extent of influence of each variable will be analysed. In addition,

towards the end, the strength of the model as a whole will also be studied.

5.1 Ordinary Least Squares Estimator & Results

The table below shows a simple OLS model with gross domestic product as the

dependent variable and inflation, exports, unemployment and FDI as the

independent variable. Table 2 shows that all of the variables are significant apart

from one. Firstly the constant coefficient is positive and significant as expected from

1980Q1 to 2014Q4. This means that the economy has been growing throughout this

period, which is true.

It is clear that as inflation increases by 1 unit the growth rate in the UK increases

by 1.07 units. This is highly significant at the 1% level. Studies have come up with

a variety of results with some concluding that inflation leads to growth and some

concluding that inflation does not. For the UK in particular during the period of study,

results have shown a clear positive relationship. Whereas in Barros (1995) study,

he found the relationship between the two variables to be statically insignificant. This

suggests that in the UK, the inflation rate plays a big role in determining economic

growth. This is similar to the conclusion Koch, Schoeman & Tonder (2005) came up

with when they was studying China but the opposite to what Chen & Feng (2000)

found when studying the relationship between the two variables. Kwan (2013)

argued the point well that depending on what point an economy is on the economic

cycle will determine the reaction that growth will have to an increase in inflation. The

26
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fact that the UK has been involved in 3 recessions throughout the period being

tested suggests that inflation does determine economic growth, however the

direction in which it does affect it depends on the point the country is on the

economic cycle. As said earlier it depends on the economic strength of the country.

Bittencourt, Van Eyden & Seleteng (2015) suggested that inflation rates above 18%

becomes detrimental to growth in the community. Therefore the fact that in the UK,

the inflation rate has always been below this level highlights another reason as to

why the inflation rate positively affects the economic growth.

Exports has a positive effect on growth. This matches the theory and as

discussed throughout the literature review. This is the same conclusion that Chen &

Feng (2000) came to when they carried out a study into the relationship between

the two pairs. Results in this study showed that as exports increases by 1 unit,

growth increase by 0.10. This suggests that as the country increases its exports

year by year, this will consequently increase the growth rate of the UK. In addition

like the previous variables, this variable is highly significant therefore emphasising

the importance of this variable as a determinant of economic growth. Through

exporting at a large rate, a country can raise factor productivity, efficiently use its

resources and increase its technological innovations. As the economy expands, the

country tends to become more integrated into international markets. This is what will

influence the economic growth in majority of countries, including the UK (Chen &

Feng, 2000, p.10).

From theory, it is known that as FDI increases, so does economic growth,

however when the regression was ran, results showed that as FDI increased by 1

unit, growth decreased by 0.002 which suggests a negative relationship. Despite

27
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this, the coefficient is so small that it is practically nothing and could in fact imply

that FDI has no effect on economic growth. Elkomy, Ingham & Read (2016) came

to a similar conclusion when talking about the effect of FDI on economic growth in

a democratic country. It was stated that “splitting the sample according to levels of

democracy reveals that for states classified as democratic, only domestic

investment was beneficial to growth; FDI, schooling, and political development are

found to have no impact whatsoever” (Elkomy, Ingham & Read, 2016, p.360). This

emphasises that the negative relationship shown in the results above could be

because of the democratic status of the UK. To add, the p value of FDI is greater

than the 10% significance level therefore making it highly insignificant. In addition

this negative relationship between economic growth and FDI could be explained

from rules and regulations within the country. For instance when a foreign investor

invests into the UK, they may have different aims and objectives to the host

government. This conflict could then result in unforeseen outcomes.

The unemployment coefficient is as expected. When analysing the results it is

apparent that the variable that causes the biggest change is unemployment. This is

because results show that as unemployment increases by 1 unit, growth decreases

by 6.70 units. This is a large change compared to the others and suggests that

unemployment is a big factor when it comes to determining economic growth. As

said above, the labour market it pivotal in a countries progression. The importance

of this is emphasised in the results shown. During the times of the recession, the

UK saw sharp spikes in its unemployment level and this could have been the

explanation behind the large drop on the country’s growth rate. The variable is

significant at the 1% level after being first differenced therefore again emphasising

the importance of this variables when running the regression. These results are

28
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similar to Tatoglu (2011) where he found there to be a negative relationship between

the first differenced unemployment rate and the GDP growth rate.

5.2 Ordinary Least Estimator with a Dummy Variable & Results

The second regression has a dummy variable for the period between 2007Q1

and 2008Q4. The second regression is there to show how growth was affected

during the time of the recession. Overall as expected the regression had a negative

effect on growth during this period. This is evident from the coefficient for the dummy

variables being -4.09 as well as being significant.

Similar to the whole period, the inflation coefficient is positive and significant.

Results show that as inflation rate goes up by 1 unit, growth will go up by 0.98 unit.

This signifies that during a recessionary period, the growth rate is slightly less

receptive to a change in inflation. This is what is expected because during a

recession regardless of whether the prices are going up, staying constant or falling,

consumers would not be consuming as much as they used to when the economy

was strong. Consequently the growth rate would not be reacting as fluently as

before. Typically the inflation rate follows the growth rate with a slight lag. This is

evident from the sharp drop in the inflation rate during previous recessions.

Likewise, the unemployment coefficient is still negative and significant as

expected. Unemployment is a determinant that is directly affected at times of

recession. Employees are the first to lose their jobs as soon as a firm is hit by the

force of a recession. From the table it is evident that as the unemployment rate

increases by 1 unit, the growth rate drops by 5.09 unit. This implies that, during a

recession, the relationship between growth and unemployment is very unequal. This

29
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is evident from the uncontrollable affect a recession has on the labour market. This

is also agreed in Claessens, Kose & Terrones (2009) study were they emphasised

that “in 90% of recessions, there is an increase in the unemployment rate, with the

rise typically three times greater in severe than in other recessions” (Claessens,

Kose & Terrones, 2009, p.16).

FDI has gone from having an inverse relationship during the overall period to

a positive relationship. Results indicate that if the FDI rate increases by 1 unit, the

GDP rate increases by 0.004 units. This matches the theory as an increase in FDI

should lead to an increase in economic growth. However the relationship is

insignificant with p values greater than the 5% significance level. These coefficients

might be insignificant because when a country is going through a recession foreign

countries might not be inclined to invest in such a country. For example, during a

recession foreign investors would not want to invest in a country that is not doing so

well. This will explain why the coefficients for FDI is insignificant. As mentioned in

Poulsen & Hufbauer (2011) study, all main FDI components have been negatively

affected since 2007. He further added that, “not only have host countries not tried

to attract new FDI during the crisis, they have struggled to retain what they already

have” (Poulsen & Hufbauer 2011, p.3). This emphasises the struggle many host

countries go through at times of a recession. In addition, Poulsen & Hufbauer

(2011), went on to state that the most important determinant of FDI is economic

growth. Therefore during a recession when economic growth is very low, FDI will be

low too. This makes sense and explains why during the recession the relationship

between growth and FDI changes and becomes identical.

Exports has a positive relationship which is similar to how it was in the original

model. However the coefficient is insignificant unlike the original model. This is

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because the period that is being tested in the second regression is the recession

from 2007Q1 to 2008Q4. The exporting country may not be exporting at a regular

rate during a recession and for that reason, during a recessionary period as the

growth rate drops so does the export rate. During a recession, jobs are lost, firms

struggle producing and confidence is lost in consumers therefore the rate would not

be as great as if the country’s economy was expanding. In Claessens, Kose &

Terrones (2009) study of the effects of a recession on an economy, they found that

exports drop more in severe recessions in comparison to other recessions

(Claessens, Kose & Terrones, 2009, p.16). Due to the financial situation and the

amount of countries that were affected during the crisis puts the recent recession as

one of the worst seen for a long time.

Adjusted 𝑟 2 is a variation of the 𝑟 2 value. It adjusts for the number of

independent variables that have been used in the model. Looking at table 2, the

adjusted 𝑟 2 value is 63.8%. Therefore suggesting that majority of economic growth

is determined by the independent variables that are used in this study. Table 3’s

adjusted 𝑟 2 value is higher at 69.4%, however as this model has a dummy variable,

the adjusted 𝑟 2 value may have been inflated because of this.

To test for the significance of the whole model, a joint test, called the f test is

used. The f value for both regressions imply that the models reject the null

hypothesis and conclude that the models are significant. Both of the f values are

significant at the 1% significance level.

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6. Conclusion

This research aimed to access the effects that certain determinants have upon

economic growth in the UK. Results infer that the variables tested in this study are

highly influential in the economic growth rate. In particular, economic unemployment

plays a key role in how well the economy is progressing. As expected, nearly all the

variables matched the theoretical assumptions made by previous researchers within

the field.

In order to delve deeper into the association between the determinants and

economic growth, a dummy variable was used for the period 2007-2008. The

relationship held strong even through a recession, just the rates at which the growth

rate was progressing was majorly affected. This is what was expected when a

recession hit the UK.

Some may argue the limitations of the findings how, this paper has only focused

on one country without comparison of other countries. However, if many countries

and different time periods were explored; a precise conclusion could not have been

generated.

This study would have been stronger if more determinants were used. Due to

the time restriction, this study was constrained from examining several determinants

and carry out a variety of tests to depict the relationship. One crucial variable that

was left out was population. For future reference, the way in which population is

measured should be distinctively reconsidered. Many studies use fertility as a

measure of population however, to measure population, the total population of

working class people in a country should be used. This can highlight whether year

by year increases/decreases in the amount of working class people affects

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economic growth. This way of measuring is better instead of the common method;

if fertility increased in one year, this would not necessarily have any effect until the

children were of working age. Therefore it is more efficient to fast forward to about

21 years where the individuals are of working class and are in a position to

potentially contribute to increasing the economic growth in the country.

Lastly, valuable advice for future researchers when conducting investigations to

see what determines economic growth, is to be highly observant when testing for

the relationship. Due to select determinants, it can be found that the detrimental

value is reversed whereby economic growth influences the determinant.

Nevertheless, the main aim of the study was to find what determines economic

growth and results have shown a great indication of inflation, exports and

unemployment being key factors.

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7. Bibliography

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8. Appendix

UK VARIABLES TEST STATISTICS

ADF P VALUES
GDP RATE -2.98 0.04**
INFLATION RATE -3.29 0.02**
EXPORTS -4.52 0.00***
FDI -3.85 0.00***
UNEMPLOYMENT RATE -1.72 0.42
FIRST DIFFERENCED -4.08 0.00***
UNEMPLOYMENT RATE
Table 1: *,**,*** statistically significant at the 10%, 5% & 1% respectively

OLS TEST
VARIABLE COEFFICIENTS STANDARD P VALUES
ERROR
INTERCEPT C 1.718097 0.388827 0.0000***
INFLATION 1.069803 0.070693 0.0000***
EXPORTS 0.098713 0.037296 0.0091***
FDI -0.001903 0.007648 0.8039
DUNEMPLOYMENT -6.069936 0.773306 0.0000***
OBSERVATIONS 139
R SQUARED 0.648205
ADJUSTED R 0.637703
SQUARED
F STATISTIC 61.72580
PROB(F- 0.000000***
STATISTIC)
Table 2: *,**,*** statistically significant at the 10%, 5% & 1% respectively

36
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OLS TEST WITH

DUMMY VARIABLE
VARIABLE COEFFICIENTS STANDARD P VALUES
ERROR
INTERCEPT C 2.436103 0.388827 0.0000***
INFLATION 0.979372 0.070693 0.0000***
EXPORTS 0.036246 0.037296 0.0091***
FDI 0.003881 0.007648 0.8039
DUNEMPLOYMENT -5.093364 0.773306 0.0000***
RECESSION -4.086206 0.808027 0.0000***
DUMMY
OBSERVATIONS 139
R SQUARED 0.704939
ADJUSTED R 0.693847
SQUARED
F STATISTIC 63.55093
PROB(F- 0.000000***
STATISTIC)
Table 1: *,**,*** statistically significant at the 10%, 5% & 1% respectively

37